What to do if your company pays you with a red-hot stock

The stock market has been surging, with tech stocks leading the way. The rally has the potential to significantly tip the balance of an investor’s portfolio toward a few stocks.

One common scenario: Many companies, in particular tech companies, compensate employees with significant amounts of stock. So if you’ve been an Amazon employee for a couple of years, you may suddenly find yourself with an extremely undiversified portfolio, tilted heavily toward your employer.

Research from Merrill Lynch shows that people with highly concentrated positions can get hit by unrecoverable losses. And many stocks lose money. About 40% of the 13,000 stocks that were in the Russell 3000 between 1980 to 2014 experienced declines of more than 70% from their peaks.

“Recent history can be instructive here,” Andrew Porter, director of behavioral finance for Merrill Lynch Wealth Management, told Yahoo Finance. “During the dot-com bubble, many entrepreneurs maintained a wealth creation mindset with their holdings, while other investors—including their family members—were less attached to (or less confident in) the companies and took steps to diversify.”

How to diversify from a very concentrated position

According to Porter, the way to deal with this concentration is by considering the individual purposes and goals of investing instead of focusing on “speculating exactly how long or high a high-flier might fly.” And while wealth creation is often concentrated in a few stocks, managing wealth is all about managing risk and not rolling the dice.

To accomplish this, investors and savers are presented with a menu of options for dealing with these issues, and figuring out exactly how to rebalance a portfolio can be a challenge. This is not an exhaustive list, and for each option there may be tax implications and other tricky scenarios, so talking to a financial advisor is prudent if you have questions.

You could sell a little over time

To lock in gains and make sure a bad day for one company won’t wipe out your entire net worth, investors can make a plan to deal with the risk. One option is for scheduled sales, which liquidate a position over time. Selling slowly over time is one way to avoid a sudden big tax bill, especially if the stock has shot up a lot. However, this strategy has a tradeoff. Selling slowly means getting rid of risk slowly.

You could set up a 10b5-1 plan

People with inside knowledge of a company may want to make a 10b5-1 plan, which allows a person to make a schedule of sales thereby insulating them from claims of acting on nonpublic information. Some people may have unique situations that make a 10b5-1 plan tricky. Founders or people on the ground floor may have so much stock that sales could move the market significantly, driving the value down. Often, company policy will dictate what is allowed for employees, so it’s important to check with your HR department to see what restrictions you have when it comes to ditching stocks.

Dabble in derivatives

Selling isn’t the only option, of course. People with concentrated portfolios can use tax-advantaged options like a collar, which is when you buy a put option and sell a call option to limit potential losses while putting potential gains on a similar leash.

A prepaid forward is another choice, which gives an investor the ability to get liquidity to help diversify by getting a payment now and deliver the shares later.

Trading these types of derivative securities is more complicated than just buying or selling a stock, so you may not want to do this on your own. A financial advisor or a broker can help.

Put in a trailing stop order

Another simple way to stop potentially crippling losses would be to automatically sell stock if the value goes down a certain amount. Selling when a stock is plummeting isn’t always sound advice for the long term, but it does get someone out of a potentially risky position. The easy way to do this is by setting up a trailing stop order that would automatically sell if the concentrated stock’s price fell through a specified price floor. Putting in an order can be as easy as logging onto your investing platform and making a few clicks. If you’re unsure, your financial service provider can help.

It’s good to not keep all your nest eggs in one basket.

Regardless of the method, the market has often illustrated the importance of diversification time and time again. Confidence and belief in success can be a good thing, but it can blind people into thinking diversification is unattractive. Gravitating toward the familiar, extrapolation and other cognitive biases can also keep people from branching out.

“When things are going well, when a nest egg is growing—largely or solely because of one or a few stocks—it’s not exactly intuitive or natural to curb that growth in order to lessen downside risk,” said Porter. “But that’s exactly what prudent investors do, by locking in gains and rebalancing.”